In recent years, the tax framework for nonqualified executive benefit programs has become more complex and expensive to administer. In the split dollar world, there are final regulations and related guidance that must be navigated. In the deferred compensation arena, there is new Internal Revenue Code section 409A, with final regulations and other recent guidance contributing to taxation and administrative challenges.
During this same time, the taxation of executive bonus plans has remained relatively stable. Double bonus plans, where the employer provides both the savings contribution and a grossed-up bonus for income tax costs, remain an attractive option.
However, these plans may not meet a business owner’s need to retain an executive with a strong ‘handcuff.’ For the business to deduct the bonus, it can’t possess any financial interest in the life insurance policy purchased with the bonus.
As nonqualified executive benefit planners, we need to help clients find their way through the maze of tax rules and regulations. Planners should use their knowledge and insight to find the simplest and most cost-effective solutions that meet a business owner’s needs for a nonqualified executive benefit program.
With that goal in mind, new plan types will undoubtedly be created that aspire to provide a meaningful benefit, while successfully navigating the complex regulatory and taxation environment. One such opportunity exists with the short-term deferral exception to the definition of deferred compensation under IRC section 409A found in the final regulations.
Generally, the short-term deferral exception provides that if a benefit is paid in full to an executive within two-and-a-half months after the close of the tax year in which the executive becomes entitled, then compliance with the remaining rules of section 409A is not necessary. For this exception to work, the benefit must be subject to a substantial risk of forfeiture until it is vested.
The exception applied
Let’s look at a specific plan design example that fits within this exception. If an employer has an executive he or she wants to ‘lock-up’ for the next 10 years, and is willing to finance a solution, the employer may offer a nonqualified benefit program with the following simplified plan design. If the executive is still employed with the firm in 10 years, the employer will pay the executive a lump sum of $250,000 no later than 30 days following completion of the 10-year period. It may be easiest to think of this plan as a deferred executive bonus with a very strong handcuff.
From a taxation perspective, the employer gets a tax deduction when it pays the lump sum bonus to the executive. Prior to that point, the employer receives no tax benefits, unless an informal sinking fund is created to pay the benefit. This is done by purchasing a cash value life insurance policy with tax-deferral of policy cash values. The executive is taxed on the bonus when it is paid.
If a life insurance policy is used to informally finance the lump sum benefit, a portion of the policy’s death benefit could be used for an endorsement split-dollar plan to provide a tax-free death benefit for the executive’s family. The executive’s cost for this benefit is the tax due on the amount of economic benefit provided, generally measured by government Table 2001. Another portion of the death benefit could serve as key person protection for the business.
If the life insurance policy is used to informally finance the plan, a business owner has two options when it comes time to pay the bonus. The policy itself may be transferred to the executive in satisfaction of the amount owed. If this approach is used, then the fair market value of the policy must be used for valuation purposes. Alternatively, depending upon the policy funding strategy, the business may retain ownership of the policy for cost recovery purposes and use a combination of current cash flow and policy values to pay the promised lump sum.
Generally, the short term deferral exception rules of section 409A do not permit vesting prior to completion of the 10-year service period and do not allow for a subsequent deferral of the lump sum payment as the end of the service period approaches. The presence of either of these features will likely cause the plan to be non-compliant under 409A, which then must be administered and taxed accordingly. Many small business owners prefer to avoid that outcome.
While this plan design offers simplicity and a meaningful benefit, it is not for everyone. For example, due to the substantial risk of forfeiture rules, the plan design is generally not appropriate for business owners or family members of business owners.
Although the plan fits within the exception to the definition of deferred compensation in the 409A final regulations, in essence, it is still a form of deferred compensation. For this reason, executives must qualify for ‘top hat’ status, similar to other deferred compensation plans, to qualify for an exemption under ERISA.
As the dust settles over the recent round of new rules governing nonqualified executive benefits, we expect planners will continue to create new plan designs built upon the ‘sweet spots’ of the new rules.
Pete Leo is associate director for advanced solutions at the Principal Financial Group, Des Moines, Iowa. .